Next week the Office for Budget Responsibility will publish its latest assessment of the outlook for the economy and the public finances with analysis of the impact of the chancellor’s policy decisions from his autumn statement. There is a fair amount of criticism of how such assessments are made.
In many ways the most important, and most vocally expressed, criticism of the office is that it underestimates the effect of changes in tax and spending policies on incentives to supply labour and to invest.
It would definitely be a serious mistake to ignore such behavioural responses to policy changes. For example, to understand the full impact of a tax rise or cut on the public finances, it is not sufficient to simply count the cumulative gain or loss of tax revenue from the same number of taxpayers paying the new tax rate on the same level of income. One must also take into account how the resulting change in post-tax income that people or companies retain from extra hours worked, or from profit earned, affects their incentives to engage in economic activity that itself generates tax revenue.
Pushed far enough, this reasoning could lead one to conclude that cuts in tax rates could in principle pay for themselves, or increases in taxes rates could reduce overall revenue.
We at the Office for Budget Responsibility are aware of these issues and, as highlighted in a new paper on dynamic scoring, has always taken account of the behavioural effects of government policies. In the 2012 budget, the coalition government of the time cut the top rate of income tax from 50p to 45p. The “static” costing of this policy was that tax revenues would be reduced by £3.5 billion in 2015-16 if there were no change in behaviour by directly affected taxpayers. But, after allowing for a likely behavioural response — in the form of both changes in hours worked and “tax planning” — the office’s central estimate of the loss of revenue was reduced to just £100 million.
Nor is it just the dynamic effect of tax changes that is captured in our economic forecasts. In March 2020 the government announced plans to increase public sector capital spending permanently by more than 30 per cent in real terms. We estimated that if this were to transpire it would gradually but significantly increase the public sector capital stock — by about a quarter over the long term.
As we said at the time, the effects would be felt well beyond our five-year forecast horizon but could have led to an eventual increase in the size of the economy of about 2.5 per cent.
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More recently, in our last budget forecast in March, we concluded that the chancellor’s childcare and other labour market policies would increase employment by about 110,000 people. The effective cut in corporate tax on proceeds from new investment that was implied by temporary full expensing of capital spending was assessed to raise investment.
So the office does not ignore the impact of policy changes on economic behaviour — it does not have static models where people just carry on saving, working and investing the same amount regardless of how much government is putting in or taking out of their pockets. We look at a wide range of estimates from numerous studies of how behaviour does respond to incentives, be it personal retirement decisions, company decisions over investment, or decisions by those not presently in the labour force to seek work.
We are open to look at any evidence that our estimates of behavioural responses to incentives are either too large or too small.
Whether we reflect behavioural responses to incentives accurately is a fair question to ask. To claim that we are unaware of them is not.
